Fixed and adjustable rates, and qualifying ratios
Fixed-rate mortgages
With a fixed-rate mortgage, the interest rate is set when the loan is made and stays the same for the whole term (CFPB key terms). On a fully amortized fixed loan the principal and interest payment never changes, which makes budgeting simple. The borrower bears no rate risk; the lender bears all of it.
Adjustable-rate mortgages (ARMs)
An ARM has an interest rate that can change. Most ARMs start with a fixed period, then adjust on a set schedule. Three terms drive every adjustment.
| Term | What it is |
|---|---|
| Index | A market interest rate that rises and falls with general conditions. The lender does not control it. |
| Margin | Percentage points the lender adds to the index. It is set in the loan agreement and does not change after closing. |
| Fully indexed rate | Index + margin. |
New rate = index + margin, limited by the caps
Rate caps
Caps protect the borrower from large jumps. The CFPB describes three kinds:
- Initial adjustment cap: how far the rate can move the first time it adjusts after the fixed period.
- Subsequent (periodic) adjustment cap: how far it can move at each later adjustment.
- Lifetime cap: how far it can ever move above (or below) the initial rate over the life of the loan.
Worked example: an ARM starts at 4.5% with a 2% initial cap and a 5% lifetime cap. The margin is 2.75%. At the first adjustment the index is 4.5%.
- Fully indexed rate: 4.5% + 2.75% = 7.25%.
- Initial cap: 4.5% + 2% = 6.5% maximum.
- The new rate is the lower of the two, 6.5%.
- The rate can never exceed 4.5% + 5% = 9.5% over the life of the loan.
Unlike a fixed-rate loan, an ARM shifts part of the interest rate risk to the borrower: if the index rises, the payment can rise too.
Qualifying ratios
Lenders compare a borrower's payments to gross monthly income, meaning income before taxes and deductions. The two common ratios:
- Housing expense ratio (front-end): the proposed housing payment, usually principal, interest, taxes and insurance (PITI), divided by gross monthly income.
- Debt-to-income ratio (back-end, total obligations): all monthly debt payments, including the new housing payment, divided by gross monthly income. The CFPB's example: $2,000 of monthly debts on $6,000 of gross income is a 33% DTI.
The maximum ratios depend on the loan program and lender and change over time. On the exam, the question gives you the ratio to use. Three kinds of problems come up:
- Maximum payment: gross monthly income × ratio.
- Maximum housing payment under the debt ratio: (gross monthly income × debt ratio) − other monthly debts. When both ratios are given, the lower result controls.
- Income needed: payment ÷ ratio. Multiply by 12 for annual income.
Always convert annual salary to monthly first by dividing by 12.